Threats to Gentex Not as Close as They Appear

 Gentex Corporation (GNTX), by far the leading auto-dimming mirror manufacturer with 88% market share, has seen its stock rise by as much as over 30% this year, far outpacing the S&P 500. Although the stock is slightly undervalued, there are still several critical strategic issues that need to be examined regardless of valuation. Of particular concern is the threat of cameras replacing mirrors. We have long believed that this is too far in the future to be a threat to buying the stock, and new research supports this opinion.

Background and Valuation
Chairman and CEO Fred Bauer founded Gentex in 1974 to manufacture smoke-detection equipment in commercial buildings, a business it still operates today. The company moved into auto-dimming electromechanical vehicle mirrors in 1982, and in 1987 Gentex became the first auto supplier to bring electrochromic technology to the sector. Gentex has been able to use this first-mover advantage and a very consistent manufacturing process to increase its share of the auto-dimming mirror market to 88% in 2012 from 77% in 2003. Although Gentex owns nearly 700 patents related to its mirror business, the company still has to compete with its main rival,  Magna (MGA), on every new vehicle program. The consistent quality and reliability of Gentex’s manufacturing process enables Gentex to increase share off of an already large base and earn a narrow economic moat. In 2011 the company posted $1 billion in total revenue for the first time and 2012’s top line was $1.1 billion with 23.8 million mirrors shipped, compared with 8.8 million units in 2002. Gentex’s compound annual revenue growth since 2002 is an impressive 10.8%. The company’s free cash flow and return on invested capital, or ROIC, are also outstanding for a parts supplier, with ROIC typically at about 20%-25% and only declining to about 17% in 2009 during the global recession. Free cash flow, defined as cash from operations less capital expenditures, has averaged 81% of net income since 2002, so the company has very high earnings quality as well as a fortress balance sheet with no debt, no unions, no pension or OPEB, and $4.73 per diluted share of cash and investments as of March 31. Despite Gentex’s positive attributes, we do not see it earning a wide moat, since, like all auto suppliers, it still has to give automakers annual price reductions and is subject to the cyclicality of the auto industry.

Our discounted cash flow model's fair value estimate of $27 assumes a continued increase in global auto-dimming mirror penetration based on historical performance and that North American penetration is only 50%-55%, according to Gentex. We also believe that as Asian consumers become wealthier they will want and will be able to afford more safety content such as auto-dimming mirrors. We assume a slight decline in market share for conservatism to 87% from 88% today. We forecast revenue to increase about 5% on a five-year CAGR basis and operating margins to average over 22% during our five-year explicit forecast period. Top-line growth is important to Gentex because margin expansion is difficult, with automakers always seeking price concessions. We think the firm's expertise and high-tech products will get gross margins back over 36% by 2016. We forecast capital expenditures of more than 7% of revenue per year on average and research and development expense of about 8% of revenue on average. We are encouraged to see Gentex beat its first-quarter gross margin forecast with a sequential increase rather than a decline as the company originally predicted. We see the most significant risks to the stock price coming from the Federal Reserve ending quantitative easing, continued declines in European demand into 2014, and Gentex being unable to innovate again to justify higher average selling prices, or ASP.

Although Europe is the company's largest market in terms of unit volume at 41%, Gentex’s European exposure is mostly with two of Europe’s best automakers,  Volkswagen (VOW) and  Daimler (DAI). Thus, we think any sell-offs from European macroeconomic issues could present an excellent buying opportunity.

Are Mirrors Going to Disappear?
One criticism of Gentex is that the company might one day be threatened by cameras replacing mirrors (auto-dimming or otherwise) in automobiles. Cameras already play a role in automotive safety, such as with rear camera display, or RCD, including Gentex’s RCD mirror, and active safety features, such as lane departure, so it is understandable to extrapolate this technology onto mirrors. This issue needs to be looked at from regulatory, technology, and cost perspectives, and we think that, as with many innovations, people mistakenly think something is imminent once it is technologically feasible. As we have seen with electric vehicles, the availability of the technology alone does not make something commonplace.

We have spoken to multiple automakers about cameras replacing mirrors. One large automaker is open to the possibility of mirrors being replaced by some sort of substitute but has no plans to make a change nor is aware of any regulatory plans for a change. Our most revealing conversation on the issue was with representatives of  Ford’s (F) automotive safety office and supports our view that any threat of replacement, even if real, is a long time away. We are confident on this assertion for several reasons, the most practical of which is that Ford has not had any discussions with anyone about mirrors going away, nor even heard of the issue, until we brought up the subject. Cost is another major factor. Ford does not see a time in the medium term, which it defines as over a decade from now, in which a camera would cost the same as a mirror owing to the extra costs to display the camera image. Furthermore, with cameras already on about half of Ford’s North American vehicles, the company thinks that a significant amount of economies of scale for cameras have already been realized in the auto industry. Ford told us that any additional camera volume would allow it to cut its camera costs by at most 15%. This data point suggests to us that OEMs will not be rushing to eliminate mirrors as there is not a major financial benefit to doing so.

Technology and regulation also need to be considered. Regarding technology, cameras in place of mirrors would have to be tested for many variables such as weather or functionality while towing. Regarding regulation, current U.S. law under Federal Motor Vehicle Safety Standard 111 requires all passenger cars to have a rearview mirror, a driver’s side mirror, and in some cases a passenger side mirror. The National Highway Traffic Safety Administration, or NHTSA, will not be rash in making a decision to remove mirrors. NHTSA will be very thorough in its data gathering and will seek comments from auto trade groups, automakers, and suppliers before changing any rules, all of which takes time. Automakers would want any new technology to meet voluntary distracted-driving guidelines released by NHTSA on April 23 that require drivers to not have their eyes off the road for more than two seconds. State regulations also affect the industry’s ability to change away from mirrors as some states prohibit moving video images while driving (according to Ford). Cameras replacing mirrors would require states to individually change their laws, which again takes a lot of time.

So What’s Next?
Gentex’s stock rose quickly into the $30s in early 2011 as NHTSA’s preliminary KTSA implementation rules suggested a windfall for Gentex’s RCD mirrors. This incremental business is not likely to happen in any large volume as Gentex’s customers are moving toward the center stack for RCD rather than using a mirror. We think this trend is because of a larger screen size relative to the mirror.

Given what we see as weak RCD prospects for Gentex, a logical question is, what is the next innovation? The company wisely likes to pursue scalable businesses, so the dimmable airplane windows on the Boeing 787 and Beechcraft King Air 350i in our opinion have tremendous option value but are still too small to contribute meaningful value anytime soon. Guidance on the 787 program is for $50 million of revenue over the first five years of production, with the majority of that revenue going to Gentex instead of its partner PPG Aerospace. Gentex delivered its first windows to Boeing in the second quarter of 2010. It is quite possible that one day Gentex will have an entire aviation segment that sells these windows to every major airline maker, but we think it is far too early to consider buying the stock for that reason. Gentex’s revenue from fire protection and airplane windows combined was only 2.1% of total revenue last year.

We see Gentex’s SmartBeam headlight product having growth potential before a dramatic increase in airplane windows. Gentex first sold SmartBeam in 2004 and expects 10%-15% growth in 2013 on top of the nearly 1.2 million units delivered in 2012. SmartBeam uses decision-making algorithms and Gentex’s camera with complementary metal oxide semiconductor technology, or CMOS, integrated into the mirror to allow a vehicle’s high-beam headlights (i.e., the “brights”) to automatically adjust to objects outside the vehicle. Gentex states this function has safety benefits as research from the U.S. and Europe shows drivers are outdriving low-beam lights at 50 miles per hour. Gentex has also cited a 2006 University of Michigan Transportation Institute study that says North American drivers use their high beams correctly less than 25% of the time. Gentex sells SmartBeam for about 80 vehicle models, primarily in Europe, in two types. The first SmartBeam program is called High Beam Assist, or HBA, which automatically turns high beams on when no other vehicles are present and turns them off in the presence of oncoming traffic. In 2012, Gentex began selling a more advanced SmartBeam product called dynamic forward lighting, or DFL. DFL allows drivers to have their high beams on all the time since it projects light around oncoming traffic. This application also has other safety benefits such as identifying objects or pedestrians on the side of the road faster than with normal headlights, and light can be angled around turns and adapted for tunnels and fog. Readers wishing to see DFL in action should watch a very interesting video from Gentex by clicking the screen next to the DFL paragraph on Gentex’s website.

DFL cannot be sold in the United States because Department of Transportation rules on headlights (unchanged from principles first established in 1968) fail to account for this new technology. Federal Motor Vehicle Safety Standard 108, or FMVSS, last updated in 1999, says headlights must switch between a low and high beam setting--a requirement rendered archaic now that DFL technology allows high beams to be on all the time. NHTSA agreed this year to study the issue and has reached out to the Society of Automotive Engineers for help. NHTSA also issued a request for comments in the Federal Register on April 4 on U.S. New Car Assessment Program rules, or NCAP, last updated in 2011. The document states the agency is not seeking comments on lighting systems that fail to meet FMVSS 108 but is seeking comments on systems that do. Perhaps this dialogue and OEM pressure from firms such as  Toyota (TM) and Volkswagen’s Audi will eventually lead to amending Standard 108 to allow high beams to always be on.

Change is likely still at least a year or more away, but we see no reason why regulators would not eventually adapt to current technology. NHTSA just needs time to test comparable systems and gather data. Such a change could be a boost for Gentex, but it is a crowded space; several other suppliers offer HBA technology and automakers such as Audi are developing their own DFL-type systems. The April NCAP comment request also asked for input on active safety such as lane departure and pedestrian detection technology, which currently are not part of the United States’ 5-star rating program. Incorporating these features into U.S. NCAP rules would be both positive and negative for Gentex as its products could be put into more vehicles, but larger suppliers may have their own technology integrated into a package that could exclude Gentex. Safety products are often bundled into expensive option packages by the automakers for consumers to purchase as consumers are not always aware of what they need, as well as to reduce automakers’ build complexity. Gentex’s overall unit ASP in the first quarter was $40.95, but advanced feature mirrors such as RCD and SmartBeam can sell for more than $75 a unit (interior mirror ASPs can go up to $250) so advanced feature mirrors that can bring active safety or other high-tech benefits to OEMs and consumers will boost Gentex’s top line.

Mobileye: A Partner, a Competitor, an Opportunity
Last May, Gentex announced a long-awaited lane-departure product. The driver-assist system is for Ford and is made in conjunction with Israeli automotive safety technology firm Mobileye. Mobileye is a privately held company that although small has established itself as a leader in camera technology for the auto industry, especially for lane-departure systems. Ford insisted Gentex use Mobileye’s camera technology since Mobileye is a leader in driver-assist. Driver-assist is much more complex than SmartBeam owing to more RAM requirements, and Mobileye has a much higher-resolution CMOS camera than Gentex’s cameras used for SmartBeam. Gentex spent two and a half years figuring out the complex integration of its products with Mobileye’s patented algorithms and EyeQ vision-system-on-a-chip as well as how to integrate all those systems with the vehicle in question. The result is a driver-assist package that combines Gentex’s HBA SmartBeam technology with Mobileye’s lane-departure product, all integrated into a Gentex interior auto-dimming mirror. The initial product is part of a $6,000 package on the Ford Explorer and has since been expanded onto the Lincoln MKS sedan MKT crossover. We expect the driver-assist product to go onto more vehicle programs over time. Gentex has to be tight-lipped on pricing to keep its customers happy but has told investors that the product is more than $5 a unit compared with RCD mirrors, which have ASPs of more than $75. Driver-assist gross margins will be below corporate average of the low- to mid-30% range, but dollar profit will be higher and margins are expected to revert to average levels as Gentex gets more volume. Gentex could have developed its own camera system for lane departure, but it would have taken years and then would still have to be proved to OEMs as at least equal if not superior to Mobileye’s technology. Mobileye’s expertise and relationships with other suppliers, along with its own products such as its Intelligent High-Beam Control, or IHC, product (a competitor to Gentex’s SmartBeam HBA), raise the question of whether Gentex should use its cash hoard to acquire Mobileye.

We think Gentex should acquire Mobileye for several reasons. We see Gentex at risk for one day being removed from any partnership that integrates driver-assist with SmartBeam or any other Gentex mirror application. Since Mobileye's IHC competes with Gentex's HBA product, Mobileye might also develop a DFL competitor. Automakers could then just use Mobileye for all aspects of driver-assist by not using the mirror. Gentex can mitigate this threat with constant innovation, which it is always willing to do (we call Gentex “the 3M of mirrors”), but acquiring Mobileye now while it’s still small could save a lot of Gentex’s time and R&D dollars by not having to invent technology superior to Mobileye’s. Active safety is a very high growth area to be in for the next decade, and acquiring Mobileye could allow Gentex to be a much larger player in this fast-growing space. Leading automotive safety supplier  Autoliv (ALV) claims to have 20% of the active safety market on $218 million of organic active safety revenue in 2012. The company sees its active safety share at 24% by 2015 and $500 million of organic active safety revenue. This math implies a total active safety market of $1.1 billion last year growing to nearly $2.1 billion by 2015.

Regulation trends also support the acquisition. European NCAP star-rating rules will require driver-assist products such as lane departure, autonomous braking, pedestrian detection, and speed assist for a 5-star rating starting in 2014 and will be required for a 4-star rating in 2017. With Europe adopting the technology, we expect automakers to continue to press NHTSA to bring U.S. NCAP closer to European requirements. The U.S. seems to be going down that path with the April request for comments discussed earlier in this report. Finally, acquiring Mobileye would alleviate Gentex’s cash hoard, which has been a consistent point of contention with investors in our analyst day meetings over the years. We normally think having a lot of cash and no debt is a very good problem to have in the viciously cyclical auto industry, but risks such as the replacement of mirrors in the distant future and Gentex not having camera technology for lane departure merit an acquisition in our opinion.

This argument raises the question of what Mobileye is worth. Information on the private company is very scarce, but an April 2012 story in Israeli business newspaper Calcalist cited estimated 2012 sales of $45 million. In October 2012, a Reuters story quoted Mobileye cofounder and chief technology officer Amnon Shashua saying the company has annual revenue of “well above $50 million,” is profitable, and doubling sales in each of the past three years along with holding more than $100 million in cash. The company does plan to have an IPO in the U.S. in “another year or two.” Mobileye raised $130 million through Morgan Stanley in 2007 in a private placement and an additional $37 million in 2010, with a reported company value at that time of $740 million after money, per Israeli business site Globes. We think last-round investors would be looking for 2 to 4 times $740 million to exit their investment, which puts a price for Mobileye on the low end of $1.5 billion. We think Gentex should act now as Mobileye’s value will likely keep growing before its IPO, and other Tier 1 suppliers such as  Delphi (DLPH), Magna, or Autoliv may also be interested.

A price of $1.5 billion is a lot of money for Gentex to spend, but it is not impossible. Gentex finished the first quarter with $676.7 million of cash and investments, with nearly all of that amount in the U.S. Gentex could spend half of its cash and investments ($338.4 million) and finance the remaining nearly $1.2 billion from a 10-year bond issue at 4%, according to estimates by our credit team. This method allows Gentex to retain plenty of cash in case of a business downturn and it can rebuild its cash balance over time. Gentex could instead spend $1.5 billion to try to make technology that is superior to Mobileye’s, but by Gentex’s own admission last May, this would take several years. During that time Mobileye could continue to forge more relationships with Gentex’s customers. If Gentex acquired Mobileye then Gentex becomes the leading provider of critical active safety features such as lane departure, protects its SmartBeam business, and puts its cash to work.

Despite our strategic argument, we would be very surprised if Gentex attempted to buy Mobileye. Management is extremely fiscally conservative and debt-averse, so we do not see it willing to take on any debt, let alone over $1 billion worth. We participated in a Mobileye discussion with management during Gentex’s May 22 analyst day, and management stated that it is not a wise move for Gentex to pursue technologies outside of its core competency area of the mirror and also seemed concerned about the liability risk for camera makers of driver-assist systems. These comments suggest to us that no acquisition is coming since Gentex is the dominant mirror supplier with 88% share, so any growth from its core mirror competency will be organic. These comments also suggest that there will not be large investment to make a camera and other systems that can beat Mobileye’s lane-departure product. Another reason a deal seems unlikely is that Mobileye can probably get more than $1.5 billion if it waits for an IPO. Although Gentex’s own innovations such as SmartBeam are likely safe for several years, we think the company is at risk of being left out of the active safety boom should suppliers like Mobileye find a way to make the mirror redundant for active safety. Gentex’s success will continue to come from innovation, so we think the market is eagerly awaiting the next “wow” product. In the midterm, however, we think the most likely catalysts are new contracts for airplane windows and the U.S. eventually allowing SmartBeam’s DFL technology.

So What’s the Capital Allocation Policy if Gentex Does Not Pursue M&A?
Our takeaway on capital allocation from the analyst day is to expect more of the same. We calculate that cash and investments totaled $4.73 per share as of March 31, and should the status quo continue, cash and investments will continue to grow indefinitely according to our model to nearly $7 per share by 2017. Management’s rationale for conservatism is that Chairman, CEO, and founder Fred Bauer always wants cash on hand for negative surprises as well as to ensure that Gentex will not be responsible for an automaker stopping a vehicle’s production line. Strong cash on hand allows Gentex to have access to its suppliers in times of uncertainty, such as after the natural disasters in Japan and Thailand in 2011, since suppliers know Gentex will pay them. We agree with a need for a strong balance sheet in the auto industry, but Gentex is in the fortunate position of now having far more cash than it needs.

Gentex is an incredibly consistent free cash flow generator with no negative free cash flow years per our records going back through 1997. We only like to see share repurchases when a stock is trading well below our fair value estimate, and management is far too slow to pull the trigger on buybacks in our opinion. The company repurchased shares in the third quarter of 2012 (for the first time since fourth-quarter 2008) at a weighted average price per our calculation of $17.09, so we would not expect further buybacks until the stock returns to a similar level. The company’s current authorization is for 4 million shares. As for the dividend, it remains safe thanks to the uncertainty on U.S. tax law resolved in January. Gentex responded to this legislation with an 8% dividend increase in February to $0.14 a quarter which puts the yield currently at about 2.4%. This yield is not terrible, but given that Gentex will likely continue to increase its cash hoard, rarely repurchases shares, and does not have any major need to increase capital expenditures, we would like to see a special dividend of at least $200 million. Gentex will likely generate over $200 million this year alone, so a special dividend would not be difficult to cover. We would rather see shareholders utilize the cash than Gentex use it to hold for nearly zero return. Gentex does invest part of its cash in blue-chip equities, but we think investors can do this themselves. Bauer has an incentive to pay a special dividend, too, since he owns 3.3% of the shares.

A company that gushes free cash flow, has a debt free balance sheet with nearly 90% market share, almost $5 per share of cash and investments, and a 70-year-old founder as chairman and CEO does raise the question, is Gentex an LBO candidate? Gentex recently let its shareholder rights plan expire in response to shareholder requests. We have no reason to think Bauer is looking to retire, but if he did, Gentex would make an attractive target to a private equity firm that is comfortable with the threat of cameras replacing mirrors. We consider the odds of a leveraged buyout actually occurring to be low, because we do not think Bauer would want to sell to a buyer who would want to move Gentex’s manufacturing out of western Michigan for lower labor costs. One of Gentex’s best advantages is its quality and reliability with automakers. It takes decades to earn and maintain the trust of firms such as Toyota, and we think a private equity firm that thinks a Gentex mirror can be identically designed and manufactured in Asia underestimates the importance of consistency in the manufacturing process. Another reason against an LBO is that Bauer is not a majority shareholder, so he does not have to put Gentex up for sale to monetize his stake should he retire.